THE RISE OF ESG INDICES

Institutional investors interested in sustainable investing are increasingly recognising ESG index tracker funds as a viable, cost effective solution that offers a practical alternative to the unsustainable practices of many listed companies across the world.

A trend is starting to emerge in the indexation space in which the spotlight is fixed on the growth of benchmarks offering environment, social and governance (ESG) principles-led mandates. Various factors have motivated for this trend. For one, the introduction of King III’s principle of integrated reporting has impelled JSE-listed companies to report on ESG issues. In addition, Regulation 28 now states that institutional investors need to consider ESG factors in their investment process.

This retirement reform by Government has stimulated more interest in passive investing, and index tracker investment products in particular. The impact of major corporate scandals, the 2008 financial crisis and growing awareness of key sustainability challenges have also increased the focus on corporate sustainability.

This interest in ESG factors has however not always been so. Although it is a regulatory requirement to include ESG strategies when selecting stocks, it was in the past predominately reliant on the active managers’ discretion. According to a survey done by Ernst & Young in 2013, the lack of ESG measurement tools was the main barrier deterring investors from considering ESG issues. The need for a benchmark became an apparent need in order to measure ESG application.

ESG indices are specialised analytical tools meant to reflect the prevalent ESG strategies. They offer an attractive low cost solution for investors to incorporate sustainability factors into their portfolios. And the transparency of the screening process allows investors to clearly understand the pillars being evaluated and how individual companies are rated to their peers in the same sector.

SCREENING RESPONSIBILY

In 2004, the Johannesburg Stock Exchange (JSE) became the first stock exchange in an emerging market to create a socially responsible investment (SRI) index. The intention was to provide investors with a means of identifying listed companies with sound ESG policies and practices. The index however received much criticism over the years around lack of transparency, the selection criteria and underperformance relative to the parent index.

The flawed selection criteria was demonstrated by the inclusion of stocks like Lonmin and African Bank in the index. And as the repercussions of the Marikana tragedy played themselves out and several issues emerged regarding Lonmin’s financial stability, it continued to be part of the SRI Index. Similarly, African Bank remained in the index until its suspension in August 2014. This has left very little confidence from investors on the quality of the index’s screening.

While SRI is motivated by ethical imperatives to shape the market, responsible investment needs to be clearly distinguished from SRI because its particular approach places emphasis on the financial materiality of ESG issues into mainstream investment decision making.

The responsible investment approach is therefore not premised on moral principles, but rather on the principle that ESG risks can affect the financial performance of investments and they therefore need to be carefully considered.

As the pioneering indexation managers to introduce a global ESG capability in both developed and emerging markets, Old Mutual Investment Group had the expertise and experience to introduce a sound offering to the local market. And we did.

On 1 April 2016 Old Mutual Investment Group launched the first responsible investment equity index fund in South Africa, the Old Mutual Responsible Investment Equity Index Fund. The Fund invests in companies that have high sustainability measures.

The Fund makes use of the MSCI research methodology and a best-in-class approach to target sector weights. In selecting the investment strategy, we consulted our RI team, who are very familiar with MSCI’s ESG selection process and strongly endorse this approach. MSCI was voted the best firm in ESG, corporate governance and emerging markets research in the 2015 IRRI (Independent Research in Responsible Investment) Survey. In Contrast to the aforementioned JSE SRI Index, the robust screening methodology of our index addressed both the Lonmin and African Bank issues. Lonmin was excluded from the index due to a low controversy score, while African Bank was dropped in June 2014 as their ESG scores were lower than that of their sector peers.

ANALYSING THE RETURNS

There has long prevailed an alleged trade-off between investment returns and allocation of capital towards companies that facilitate positive social and environmental impacts.

Research has however proven that 88% of reviewed sources find that companies with robust sustainability practices demonstrate better operational performance, which ultimately translates into higher cashflows1. And 80% of the reviewed studies demonstrate that prudent sustainability practices have a positive influence on investment performance1.

Though we cannot guarantee future outperformance, the trend below (Figure 1) endorses the fact that ESG has paid off relative to the market index. The returns of the ESG selection criteria are also far superior to that of the FTSE/JSE SRI SWIX, which has underperformed the parent index over its lifetime.

pg37_fig1

The robustness of the screening methodology is once again reflected in the return profile above. The outperformance of the Old Mutual Responsible Investment Equity Index Fund was attributed to two distinct outcomes from the screening process:

A) SABMiller was overweight due to being the best in its sector from an ESG perspective.

B) Sasol and Anglo American were not selected due to their low ESG scores and thus the fund benefited as they have both lost significant value over the period.
 
We can see a similar trend in emerging economies. When comparing the MSCI Emerging Markets Index to that of MSCI Emerging Markets ESG Index (Figure 2), there is clear value in applying ESG criteria to selecting the best stocks. Granted, South Africa is a more regulated emerging economy and the return differential is not as pronounced as in other emerging economies, however the data reflects that our market indeed behaves in a similar fashion.

pg37_fig2

In January both the JSE and S&P launched their Sustainable Investment indices. We performed research on these respective indices and found some shortcomings and hence decided to create our own custom index.

CRITERIA ASSESSED

In doing our analysis we looked as the following criteria:  
  • Research methodology and quality
  • Index construction.

KEY DIFFERENCES

  • Market coverage

The MSCI ESG Research covers 97% of the South African universe, thus the largest coverage compared with the other indices, whereas Russell investments cover only the large- and mid-cap securities.

  • Selection criteria

The Old Mutual Responsible Investment Equity Index Fund uses a best-in-class approach and thus selects the best 50% in each sector based on their ESG screening. The FTSE/Russell ESG Index uses an ESG scoring system where stocks with an ESG score greater than 2 are included in the index. This hurdle is very low as almost all stocks in their research universe are included in the index. S&P, on the other hand, selects the top 33% ESG companies in their universe for selection into the index, resulting in a very concentrated index of 24 stocks.

  • Sector exposure

The FTSE/Russell is not sector neutral and thus could be biased to a specific sector. The S&P Index attempts to be sector neutral, however due to the way their capping methodology is applied, this objective is negated due to the underweight position in the industrials sector. From what is illustrated below,

pg37_fig3

We believe that responsible investing should be transparent and accessible to everyone on the street and not just large financial institutions. Having an ESG Index as part of their investment strategy allows investors to be able to make a responsible investment choice, be it with their pension fund or their savings. Today, people care more than ever before about how financial return is made. Awareness of ESG factors as being critical in the investment process will only continue to spread and, as it does so, more and more investors will view sustainable investing as the new norm.

1 Source: Oxford, Stanford, Maastricht & Arabesque – 2014

AUTHOR


Kim Johnson
Portfolio Manager: Customised Solutions

Download

300x100_cover
Download the Tomorrow 2016 Handbook
 

CONTACT US

+27 21 509 5022

SUBSCRIBE

To our monthly newsletter
Sign up